95th Congress JOINT COXXITTEE PRINT 2d Session
REVIEW OF THE ECONOMY
REPORT or THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
TOGETHER WITH MINORITY, ADDITIONAL, AND
F L P,
Printed for the use of the Joint Economic Committee
U.S. GOVERNMENT PRINTING OFFICE 33-9580 WASHINGTON : 1978
For sale by the Superintendent of Documents, U.S. Government Printing OMce
Washington, D.C. 20402
JOINT ECONOMIC COMMITTEE (Created pursuant to see. 5(a) of Public Law 304, 79th Cong.) RICHARD BOLLING, Missouri, Chairman LLOYD BENTSEN, Texas, Vice Chairman HOUSE OF REPRESENTATIVES SENATE
HENRY S. REUSS, Wisconsin JOHN SPARKMAN, Alabama
WILLIAM S. MOORHEAD, Pennsylvania WILLIAM PROXMIRE, Wisconsin LEE H. HAMILTON, Indiana ABRAHAM RIBICOFF, Connecticut
GILLIS W. LONG, Louisiana EDWARD M. KENNEDY, Massachusetts
PARREN J. MITCHELL, Maryland GEORGE McGOVERN, South Dakota
CLARENCE J. BROWN, Ohio JACOB K. JAVITS, New York
GARRY BROWN, Michigan WILLIAM V. ROTH, JR., Delaware
MARGARET M. HECKLER, Massachusetts JAMES A. McCLURE, Idaho JOHN H. ROUSSELOT, California ORRIN G. HATCH, Utah
JOHN R. STARK, Executive Director
LouIs C. KRAUTHOFF II, Assistant Director RICHARD F. KAUFMAN, Assistant Director-General Counsel
LLOYD C. ATKINSON KENT H. HUGHES PAUL B. MANCHESTER
WILLIAM R. BUECHNER L. DOUGLAS LEE DEBORAH NORELLI MATZ
THOMAS F. DERNBURG PHILIP MCMARTIN M. CATHERINE MILLER
GEORGE It. TYLER
ROBERT H. ATEN CHARLES H. BRADFORD STEPHEN J. ENTIN
MARK R. POLICINSKI
LETTER OF TRANSMITTAL
OcTrOBER 6, 1978.
To the Members of the Joint Economic Committee:
Transmitted herewith for the use of the Joint Economic Committee and other Members of Congress is the Joint Economic Committee's "'Review of the Economy, October 1978," together with minority, additional, and supplemental views. In this report, the committee sets forth an analysis of key economic issues including an assessment of the system of floating exchange rates, a discussion of the inflation indexing of personal and corporate taxes, an examination of the feasibility of implementing a tax-based incomes policy (TIP), and an analysis of tax reduction proposals. Because these issues are controversial, we believe it is the responsibility of the Joint Economic Committee to discuss them and to inform Congress of expert opinions as we perceive them from our hearings and from other sources. We do not set forth any policy recommendations.
Chairman, Joint Economic Committee.
Digitized by the Internet Archive in 2013
Letter of transmittal ----------------------------------------------- III
General note ------------------------------------------------------ VII
I. The economic situation and outlook ----------------------------- 13
Domestic developments in 17
Developments in the current account of the balance of payments -------------------------------------------------- 25
Public sector outlook in 41
Fiscal policy ------------------------------------------ 42
Private sector outlook for 1979 ------------------------------ 50
Investment ------------------------------------------- 51
Net exports ------------------------------------------- 52
Prices and wages, 7 ----------------------------------- 55
II. Key international economic issues ------------------------------- 58
The present international payments system ------------------- 64
Managed floating and the need for surveillance ---------------- 69
Exchange rate determination under a cleanly floating system-- 74
Are volatile exchange rate movements the result of destabilizing
Central Bank intervention in foreign exchange markets ------ 84 The use of monetary policy for external purposes ------------ 88
Toward an assessment of floating exchange rates ------------ 92
The need for the international coordination of macroeconomic
policies ------------------------------------------------- 104
The need to reverse the tide of growing protectionism ---------- ill The continuing need to recycle surpluses 117
III. Key domestic policy 124
Productivity and 127
Tax policy and inflation ------------------------------------ 145
Need for tax reduction --------------------------------- 145
Inflation correction of the individual income tax ----------- 147
Property taxes ---------------------------------------- 162
The Kemp-Roth tax reduction proposal ------------------ 172
Incomes policy to combat 180
Additional views of Senator William Proxmire ------------------------- 191
Federal budget 202
Shortages and supply 210
The harmful effects of 212
Harmful effects on individuals ------------------------- 212
Harmful effects on 218
Distortions of relative prices -------------------------- 222
IL Inflation- Continued page
Policies to curb 223
Fiscal responsibility and the budget 224
Delay minimum wage 227
Reduce Federal 229
Proposals not 231
Price and wage 231
Tax-based incomes policy ----------------------------- 232
111. Monetary policy --------------------------------------------- 236
IV. International 238
The falling 238
The basic 239
A substantive 240
The budget and the trade deficit ----------------------- 241
Inflation, the trade deficit, and the run on the dollar 242 Can we pay 244
Nonsolutions to the dollar 244
Nonsolution 1: The energy 245
Nonsolution 2: Wait for the cheaper dollar to boost exports 248 The "J" 248
Nonsolution 3: Swap agreements ----------------------- 252
G lobal consequences of the dollar crisis 254
V. Tax changes and fiscal 257
Enlightened tax 257
Taxation and economic 263
The need for 263
Personal income tax 267
Corporate tax 271
VI. Productivity and capital formation ----------------------------- 280
Investment ratio ----------------------------------------- 281
Government regulation 285
Demographic composition of the labor 287
Policies to stimulate productivity growth 288
VIL Urban 293
VIII. Taxpayer revolt ---------------------------------------------- 303
Additional views of Senator Jacob K. Javits -------------------------- 315
Additional views of Representative Clarence J. Brown and Representative
John H. 223
Supplemental views of Representative Clarence J. Brown--------------- 327
Additional views of Senator William V. Roth, Jr 332
Additional views of Representative Garry 3 45)
Additional views of Representative Margaret M. Heckler- 348
Additional views of Senator James A. McClure ,And Senator Orrin G.
Statistical data used in this report were the, most accurate available on October 1, 1979. Information released between October 1, and October 10 could not be incorporated in this report. However, it would not change either the analysis or the conclusions.
Unlike our annual Joint Economic R
which is mandated under the Employment Act and must deal comprehensively with current economic issues, the Review of the Economy, October 1978 of the Joint Economic Committee provides an opportunity for selective and indepth analysis of economic problems that the Committee feels to be particularly timely, pressing, or of longer range significance.
Many of the issues discussed in this Report -- for example, the inflation indexing of personal and corporate taxes, the feasibility of implementing a tax-based incomes policy (TIP), and the system of floating exchange rates are highly
controversial. We believe it is the Committee's responsibility to discuss these controversial matters and to inform Congress of expert opinions drawn from our hearings and other sources* Thus, we do not make any specific policy recommendations in this Report,
Last year our Midyear Review focused on inflation as a serious enemy of continued prosperity and growth. We also concentrated on monetary policy and analyzed the inappropriateness of the mix of monetary and fiscal policies during the recovery from the recession of 1974-75. In addition, we called attention to the poor coordination of fiscal and monetary policies. Recommendations designed to rectify these deficiencies were made both in the 1977 Midyear Review of the Economy and in the 1978 Joint Economic Report issued last March, l/
l/ The 1977 Midyear Review of the Economy;
Report of the Joint Economic Committee,
Congress of the United States, together with Minority and Additional Views, September 26, 1977. The 1978 Joint Economic Report; Report of the Joint Economic Committee, Congress of the United States on the January 1978 Economic Report of the President together with Minority and Additional Views, March 21, 1978*
Our view that restrictive monetary policy has been partly responsible for the poor performance of capital spending and productivity growth in the recovery is now widely accepted. Moreover, the Federal Reserve has now apparently recognized the need for greater coordination of monetary and fiscal policies. Finally, most of the Committee's recommendations to improve the coordination of monetary and fiscal policy have been incorporated into the HumphreyHawkins bill.
When we planned our Midyear Hearings of
June and July, we decided to pay particular attention to international economic problems, especially problems of international payments, We have avoided a lengthy discussion of trade policy questions, not because they are not important, or less important than international payments problems, but because we have only recently begun to examine these issues in detail. Our Subcommittee on International Economics has just begun that process with a focus on the need for a national export policy. The
export performance of the United States over the past several years has been disappointing. We feel it is necessary to determine the reasons for the apparent loss in competitiveness of our export industries. The JEC's Subcommittee on International Economics will issue a study on this issue in the near future.
The stagnant world economy inhibits recovery and accounts for much of the present weakness of the dollar. Domestic employment considerations caused by stagnation have prompted a number of countries to abandon trade liberalization in favor of restrictive commercial policies to protect their domestic industries. Some countries have also engaged
in foreign exchange market intervention to protect their export industries. Continued economic stagnation thus poses a constant threat both to the goal of freer trade and to the flexible exchange rate system,
Because the world business cycle is out of phase another dimension has been added to the problem of stagnation. Although, the United States has enjoyed moderately rapid recovery from the recession, most industrial countries have continued along a path of inadequate growth. A weak world economy has kept the rate of growth for U.S. exports well below the growth rate for imports, The result has been a much larger current account deficit. Since a current account deficit means that we are a net consumer of foreign produced goods and services, the U.S. trade deficit subtracts from aggregate demand. Lower aggregate demand, in turn, creates pressures to continue a large Federal budget deficit to offset restrictive effects on the economy. The current account deficit in the U.S* balance of payments, finally, is a major source of the dollar's weakness in foreign exchange markets,
Our study of the international economic situation suggests that it is not possible to achieve balance-of-payments equilibrium and exchange rate stability when growth rates of individual countries are out of phase. In point of fact, it may not be possible to achieve external equilibrium without better coordination and synchronization of the domestic stabilization policies of the world's leading economies. One of the great advantages of the flexible exchange rate system is that it tends to provide countries with a larger degree of macroeconomic independence because the effects of external shocks can be cushioned by exchange rate
Variations. Complete independence has not been achieved, however, and the need for coordination and synchronization continues to be great.
The shock-proofing mechanism that clean floating is intended to provide has been impaired, in part, because the fluidity of international capital movements has tended to interfere with exchange rate adjustments, and because countries have not permitted foreign exchange markets to operate freely. As under the old system, these countries have intervened by purchasing and selling foreign currencies in exchange for domestic currencies. Unless this trend is abated, it will degenerate into the readoption of the rigid system of fixed exchange rates that prevailed in the 1950s and 1960s.
The world economy would benefit from a set of orderly rules for combating generalized stagnation, More rapid economic growth should be provided by countries with strong currencies and balance-of-payments surpluses, If internal expansion is more rapid in the surplus countries, current account deficits and surpluses will be reduced all around, and weak currencies will be strengthened. The experience in the last two years, however, has been the opposite, The United States' net export position moved from surplus into deficit near mid-1976, and the deficit has widened considerably since that time. To a large extent, this deterioration was caused by more rapid recovery in the United States than elsewhere. A Consequence of the deterioration has been the weakening of the dollar and the further strengthening of the strong currencies of West Germany and Japan, The recent trend, therefore, has been toward a widening disequilibrium that neither benefits nor pleases any party, and that
.threatens to produce further disruption and possible breakdown in the world's trade and payments system,
The depreciation of the dollar has meant higher import costs. This has added to our inflation rate, but it has also improved the competitiveness of our export industries
which should eventually contribute to the growth of our economy. At the same time, the appreciation of other currencies has slowed inflation rates abroad, put foreign export industries at a competitive disadvantage, and contributed to the continuing economic sluggishness of several key industrial countries.
In our view Germany and Japan ought to have been stimulating their economies by monetary and fiscal measures. Instead, both countries chose to attempt to protect their economies by artificially maintaining the competitiveness of their export industries through intervention in foreign exchange markets. The absence of coordinated international recovery has proved to be an impediment to the stability of the world economy. The absence of orderly adjustment is also jeopardizing the successful operation of the system of flexible exchange rates. When everyone waits for the other country to provide the locomotive, stagnation and the breakdown of trade and payments relations are the natural consequences. All country cannot recover by trying to steal employment from each other.
There is, in fact, a move to devise international economic rules of conduct -so-called surveillance" rules -- to be followed by countries experiencing balanceof-payments problems in order to ensure an orderly adjustment process. We fear, however,
that the rules ultimately devised will be of the wrong kind because there is danger that the surveillance rules will be confined to rules for exchange market intervention, and not for the conduct of domestic macroeconomic policies.
The system of fixed exchange rates that existed under Bretton Woods as
administered by the International Monetary Fund -- proved to be ultimately damaging because it placed pressure on deficit countries to deflate their economies. Since no corresponding pressure to expand was placed on surplus countries, the result of the asymmetrical pressure was a bias toward slower growth and higher unemployment, We do not wish to return to such a defective system,
The chapter on international trade and payments reviews these developments and reexamines the Committee's view that flexible exchange rates should be continued, We also examine the recent intellectual attack on flexible exchange rates by those who call themselves global monetarists. Our
conclusion is that the global monetarist view is incorrect, and that the flexible exchange rate system remains the preferred system. This is not to say that small open economies might not be better off to 3oin larger currency unions. We should, in fact, be prepared to cooperate in efforts to achieve monetary integration among countries as long as such cooperative efforts are not used by a country or a group of countries to gain
unfair competitive advantage.
While this report emphasizes the international payments system, several recent domestic developments are of critical importance to the economic health of the
United States. Chapter III reviews these developments, explains their
interrelationships, and discusses various proposals that have been suggested as possible solutions.
To begin on an upbeat note, employment in the economy has increased at an extraordinary pace. About 4 million civilian jobs have been created since the middle of last year and the unemployment rate has dropped a full percentage point. Unfortunately, the rapid growth in employment has not been matched by exceptionally rapid growth of real output. Each worker, therefore, is producing less than we would like, Put differently, the productivity performance has been extremely disappointing. During the first quarter, productivity in the private business sector fell at an annual rate of 4.7 percent, Although productivity in manufacturing picked up in the second quarter to a rate of 7,3 percent, after two quarters of decline, overall productivity in private business grew at a meager rate of 0.1 percent.
When productivity slumps, unit labor costs tend to rise more rapidly, which translates into a faster rate of increase in commodity prices. In the first quarter, unit labor
costs in the private business sector rose at a rate of 17.4 percent. This was followed by a lower, though still excessively high, increase of 7.8 percent in the second
Combined with rapidly increasing farm prices, the growth of unit labor costs caused a much faster rate of increase in producer and consumer prices. Consumer prices rose by
6.8 percent during 1977, but jumped to a rate of 9.3 percent in the first quarter of 1978, and to an even higher rate of 11.4 percent in
the second quarter. The result has been a double digit rate of 10.4 percent for the first half of the year.
Slow growth of output and output per manhour relative to the growth of employment
and labor force, has held back the rapid rise in per capita income that the American people have come to expect. This situation has been aggravated by reductions in take-home pay,
caused by rapidly rising payroll taxes and by the negative effects of inflation that tend to push taxpayers into higher tax brackets. Inflation also raises property taxes and penalizes homeowners who cannot sell their homes except on pain of a heavy capital gains tax on largely paper profits. Inflation, finally, penalizes small savers whose interest earnings rarely exceed the rate at which their savings are eroded by inflation.
The stagnation of productivity and real income growth, combined with the effects of inflation on the system of progressive taxation of money income, have created a climate in which our citizens are attempting to increase their incomes by reducing government revenue. People say they are, tired of over-regulation and of too much government attempting to do too many things. What their complaints also appear to reflect is real income stagnation and arbitrary and burdensome inflation-caused increases in taxation.
Clearly, we must deal with a number of crucial domestic economic policy issues.
First, why is growth of output per manhour so low? Portions of Chapter'III of this Report are devoted to an analysis of productivity. The analysis points to a number of policy prescriptions designed to raise the investment share of gross national product
(GNP), We propose, as we have in the past, that the monetary-fiscal mix be shifted in a direction that fosters a higher investmentlower consumption mix of aggregate spending. more significantly, Chapter III explores the possibility of altering corporate accounting procedures for tax purposes to permit firms to expense long-lived physical assets on a basis that reflects the increase in the nominal value of these assets caused by general inflation.
We believe that the taxpayers' revolt is in part a revolt against the arbitrary and capricious effects of inflation on the tax system. We also believe that the economic outlook justifies a modest tax reduction in the, $20-$25 billion range. We do not believe, however, that this problem of inflation and this question of tax reduction should be attacked by draconian measures that have recently been proposed. Instead, we feel that the issue of inflation's effect on the tax system should be confronted directly. Chapter III outlines possible procedures for and discusses the economic effects of indexing the personal income tax. The analysis also explores inflation correction of capital assets as an alternative to capital gains tax relief. In the same chapter, income tax indexation is discussed as a way of making the economy more resistant to destabilizing shocks and possibly lowering the rate of inflation.
Because inflation is central to the problems faced by our economy, we feel the Committee should continue to explore various proposals designed to bring inflation under control. At our Midyear Hearings, a number of witnesses focused their testimony on the proposal for a tax-based Incomes policy (TIP). Without recommending or endorsing
such plans of action, the Committee has included in Chapter III a brief analysis of the general proposition. At the same time, we recognize that such proposals are subject
to a great deal of justifiable criticism from the points of view of equity, administrative feasibility, and political acceptability.
Finally, of course, our Review of the Economy, October 1978 meets the Committee's obligation to monitor and report changes in economic circumstances, and to update our forecast. In Chapter I, the surprises of the first half of the year are compared to
earlier expectations. We also present revisions in the economic outlook for the near-term future, Although there have been important unforeseen events, the basic forecast of the pattern and rate of economic growth have not changed dramatically. Inflation is worse than we thought it would be; but happily, employment is better. As expected, real growth has been quite moderate. The rapid rate of inflation, however, has forced the Federal Reserve into a more restrictive monetary posture than we had anticipated. Inflation has also been a factor in the decision by Congress to reduce and delay a cut in taxes. Although consumers are increasingly burdened with debt and are likely to slow their rate of expenditure increase, business fixed investment gives strong signs of snapping out of the doldrums, and our balance-of-payments deficit is apparently beginning to respond to improved competitive conditions caused by the decline of the dollar.
If we can avoid a monetary crunch, and if we make reasoned and responsible tax and expenditure decisions, we just might be able to maintain the expansion of the economy. And if we develop a serious and effective
anti-inflation program that does not rely on demand restriction, we might make headway against inflation as well,
I. THE ECONOMIC SITUATION AND OUTLOOK
The recovery from the recession of 1974-75 continued in the first half of 1978, though at a modest pace, as real GNP grew at a rate of 4.2 percent. From the bottom of the recession in the second quarter of 1975 to the fourth quarter of 1977, real consumer spending rose at an annual rate of 5.3 percent and real business fixed investment rose at a rate of 6.6 percent. However, during the first half of 1978 these rates were 2.2 percent and 12.4 percent respectively. Thus the first half of this year witnessed a quite remarkable and welcome transition away from consumption spending toward greater relative reliance on investment for the support of continuing
Regrettably, the outlook for the economy has deteriorated since we issued our 1978 Joint Economic Report in March. l/ At at time we considered the Administration forecast of 4.7 percent real growth in 1978 ambitious but within reason. Since that time the Administration has lowered its forecast to 4.1 percent. We concur in the need for downward revision and believe that a growth rate of 4 percent is the upper limit of what can be expected.
l/ 1978 Joint Economic Report, op., cit.,, Chapter 2, pp 10-16.
The more pessimistic appraisal of the economic outlook stems in large part from policy changes that have occurred in response to the unanticipated rapid acceleration of inflation and to the sharp drop in the international value of the dollar. These
factors have prompted the Federal Reserve to embark on a policy of monetary restriction that has moved interest rates steadily higher to levels far beyond earlier expectations. At the same time, slower growth of personal income will hold down consumer spending, a
which is aggravated by the
President's determination to limit Federal pay increases to 5.5 percent. The deteriorating inflation situation is causing Congress to pare back the Administration's original request for a $25 billion tax reduction to less than $20 billion and to delay its introduction by three months to January 1, 1979. And Federal spending is currently estimated to be substantially less than the levels which were approved in the second Concurrent Resolution on the 1978 budget. Therefore, both monetary and fiscal policy are more restrictive than we had anticipated in our March forecast, and this is the reason for lowering our forecast for
real growth in 1978,
We are by no means unique in lowering our expectations for the remainder of this year. Table I-1 shows how several econometric forecasting services have revised their projections since January. The Wharton forecast has been revised downward since Dr. F. Gerard Adams testified before the Committee in June. 2/ Other analysts are also becoming more pessimistic. For example, Dr. Gary Fromm referred in his testimony to "the significant probability that another
recession will occur beginning late this or early next year." 3/ Dr. Jay Schmiedescamp discussed the deterioration in consumer sentiment, 4/ And Dr. Henry Kaufman emphasized the volatility of our economic recovery coupled with a "dangerously high
rate of inflation." 5/
2/ Testimony of F. Gerard Adams, 1978 Midyear Hearings of the Joint Economic Committee, June 28, 1978.
3/ Testimony of Gary Fromm, 1978 Midyear Hearings of the Joint Economic Committee, July 11, 1978.
4/ Testimony of Jay Schmiedescamp, 1978 MRidyear Hearings of the Joint Economic Committee, June 28, 1978.
5/ Testimony of Henry Kaufman, 1978 Midyear Hearings of the Joint Economic Committee, June 28, 1978.
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Of course, a consensus among forecasters is no guarantee of correctness. The experience of recent years has shown forcefully that our ability to predict the future is quite limited. Nevertheless, it is necessary to do our best to anticipate
economic events and to plan accordingly. Our confidence in our own views is strengthened by the fact that different forecasters have approached the problem with different theories and different methods but have all
reached roughly the same conclusion.
Domestic Developments in 1978
A review of some of the major economic developments of 1978 can provide important information about the likely behavior of the
economy next year.
The most surprising event of the last 12 months has been the spectacular rise in civilian employment, Roughly 2 to 2.5 million new jobs are created in a normal year. But from the second quarter of 1977 to the second quarter of 1978. employment
expanded by 4 million, and the unemployment rate dropped a full percentage point to the neighborhood of 6 percent.
The employment gains in the first half of 1978 were widespread. The increase in
employment was particularly sharp among adult women. Thus, despite very large increases in labor force participation, the unemployment rate for white adult women dropped from 6.0 to 5.3 percent between the fourth quarter of 1977 and the second quarter of 1978, while the rate for nonwhite adult women fell from 11.8 to 10.9 percent.
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Adult men also made substantial gains during the first half of the year as their unemployment rate dipped below 4.0 percent in June for the first time since 1974. This improvement was shared by both whites and nonwhites alike: the unemployment rate for white adult men fell from 4.2 percent in the fourth quarter of 1977 to 3.5 percent in the second quarter of 19780, while the unemployment rate for nonwhite adult men fell from 10.1 to 8.5 percent. And teenage
unemployment, which had exceeded 20 percent during the mid months of 1975, finally fell below 15 percent in mid-1978. Unfortunately, this increase in teenage employment was not shared by nonwhite teenagers whose unemployment rate remains mired in the 35 to
40 percent range.
Some success was achieved in reducing structural unemployment during the first half of 1978. The number of persons unemployed for 15 weeks or longer decreased by about 500,000, a reduction of 27 percent. The reduction has been reasonably balanced between men and women and whites and nonwhites, but it is clearly adults who have benefited rather than teenagers. Only 20.2 percent of those now unemployed have been unemployed for more than 15 weeks. This is the lowest percentage in several years.
Surprisingly, by comparison with the dramatic drop in the unemployment rate, the growth in real output has been very modest. Indeed, on the basis of "Okun's Law" which requires output to grow at about 3.5 percent just to hold the unemployment rate constant we would have expected a much smaller
reduction in the unemployment rate than occurred during the last quarter of 1977 and the first half of 1978. This is illustrated in Chart 1-2 where the unemployment rate
~ 11 111 1 11 1 1 V ~ 1 1 I I
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derived by using Okun's Law is above the actual unemployment rate over this time period.
Okun's Law, of course, is not a precise relationship. However, as Chart 1-2 shows, the unemployment rate implied by that law, over the past few years has remained very close to the actual unemployment rate. For reasons that are not at all clear, the recent slow growth in output has been reflected in very poor productivity performance rather than in slower growth of employment, if productivity advances normally, such as is implied by the present shift from consumption to investment, Okun's Law predicts that the unemployment rate will stabilize at between 6.0 and 6.3 percent for the remainder of the year.
In summary, the various factors that
determine the outlook for employment suggest that it is highly unlikely that we will experience employment gains such as those of the past year. Rather, we will be fortunate if we maintain the gains that have been achieved. It would not even be surprising to see the employment situation deteriorate
somewhat in the near future.
One of the most promising developments of the first half of the year is the longawaited revival of capital spending. Real nonresidential fixed investment grew at an annual rate of 5.3 percent in the last half of 1977, but accelerated to a rate of 12.4 percent in the first half of 1978. And after remaining flat for almost a year, investment in nonresidential structures jumped 8.8 percent in the second quarter. Overall,
capital spending has finally moved above its prerecession peak of early 1974,
The key question is whether this investment revival will continue. Among the favorable factors are strong second quarter profits and rising operating rates that are now within 2 percentage points of their prerecession peaks. On the other hand, rising interest rates and rapid inflation pose very serious threats to the further progress of capital spending.
Interest rates have been rising rapidly all year. In past years, comparable
increases would have caused depositors to remove their funds from thrift institutions
-- which are limited by law with respect to the interest they may pay -- and this process of "disintermediation" would have dried up mortgage credit and caused housing starts to drop. Recently the Federal Reserve has permitted thrift institutions to issue nonnegotiable six-month money market certificates with interest rates that vary with and are equal to or above the Treasury bill rate. This innovation has altered the distribution of the supply of credit. In particular, investors have been able to
change the composition of their portfolios without creating the shortage of mortgage funds that normally accompanies rising interest rates, These new certificates combined with a robust secondary mortgage market provided by the Federal Government have kept housing starts strong throughout 1978,
It is important to note that while the new money market certificates have altered the distribution of credit in the economy, they have done nothing to increase its overall availability. In previous years housing tended to bear the brunt of high interest rates because housing could not successfully compete for funds. However, this burden will
now be shared by other forms of interestsensitive expenditures. Therefore, while housing may continue to remain strong
throughout 1978, this may come at the expense of nonresidential investment.
Inflation clouds the investment outlook in a number of ways. Many businessmen claim to be pessimistic because they continue to fear that wage and price controls will be
reimposed. Inflation adversely affects the supply of savings because the practice of taxing nominal capital gains causes the rate of tax on real capital gains to be raised, sometimes to over 100 percent. Perhaps most important -- and as explained in Chapter III
-- inflation causes nominal profits to be overstated because of tax laws that require physical capital to be expensed on an historical cost basis only. As a result, real profits are overtaxed so that real after-tax profits and the real rate of return on new investment are both reduced by inflation.
The testimony presented to the Committee, various capital spending anticipation surveys, and other pertinent information lead us to conclude that investment will be much weaker in the second half of 1978 than it was in the first half. The Commerce Department's survey of intentions, which forecasts growth of 5.5 to 6.0 percent for 1978 as a whole, is perhaps too pessimistic. We consider a range
of 7.0 to 7.5 percent to be a more reasonable expectation.
With the exception of 1976 the performance of productivity in the private business sector has been exceedingly disappointing, proceeding at an average annual rate of only 1.1 percent during the 1973-77 period. The productivity performance this year has been
even worse, Under the impact of the coal strike and severe winter weather, output grew more slowly than expected. However, because employment continued to grow rapidly, productivity declined at an annual rate of
2.0 percent in the f irst half of the year.
The poor performance of productivity combined with an increase in labor compensation of 11.9 percent caused unit labor costs to rise at a rate of 17.4 percent in the first quarter. The compensation figure is bloated by such factors as an increase in the legal minimum wage and increases in employer payroll taxes for
social security and unemployment insurance, so that the first quarter figures do not reflect the true trend of compensation and unit labor cost. Nevertheless, in the second quarter unit labor costs rose at a rate of 7.2 percent, which is well in excess of the 6.5 percent of 1977. There is, therefore, little doubt that the underlying rate of inflation has increased. .
Although first quarter effects are frequently described as flone-time"
compensation increases, the fact is that they happen almost every year. 1979 will be no exception. An even larger boost in social security taxes is scheduled, with the maximum taxable base rising from $17,700 to $22,900, and the combined employer-employee tax rate rising from 12.1 to 12.26 percent. The employer share will add about $5.2 billion to the wage bill. The minimum wage will rise
from $2.65 per hour to $2.90 per hour, and this will add $1.4 billion directly to the wage bill. According to the Bureau of Labor Statistics, some 5.2 million workers will be directly affected by the minimum wage increase in 1979, compai:ed to this year's 4.6 million. The combined effect of these tax
and minimum wage increases is expected to add about 2.3 percentage points to the overall annual rate of increase in labor compensation in the first quarter of 1979.
The price outlook for the remainder of the year is not favorable, although a slowing in the rate of increase of food prices may hold consumer price increases below the 10.4 percent rate of the first half of the year. However, categories other than food were also up sharply. The component for consumer commodities excluding food of the Consumer Price Index rose at a rate of 6.6 percent in the first half of the year and the services component rose at a 10.4 percent rate, Producer prices have also increased for a wide variety of categories. The overall
index of producer prices rose 11.1 percent in the first half of the year, with industrial commodities up 8.3 percent and finished goods
up 10.4 percent. It is abundantly clear that the Administration has no chance at all of achieving a deceleration in the inflation rate below the average of the preceding two years, Instead, consumer prices, which increased 6,5 percent in 1977, are likely to
increase at least 7.5 percent in 1978.
Developments in the Current Account
of the Balance of Payments
Turning to the international picture, the deteriorating foreign trade position of the United States and the accompanying decline in the value of the dollar have caused a great deal of concern. The Committee shares these concerns -- largely because balance-ofpayments problems are interfering with the appropriate conduct of domestic economic
policy. A careful evaluation is necessary to properly assess the impact of external
33-958 0 78 3
developments on our economy and a considerable portion of this report is
therefore devoted to an analysis of international monetary problems. This
section provides the background information needed for that analysis.
The recent history of United States foreign trade is summarized in Table 1-2. Net exports declined from a surplus of $20.4 billion in 1975 to a deficit of $11.1 billion in 1977. The deficit then reached an annual rate of $24.1 billion in the first quarter of 1978, but improved to $10.2 billion in the second quarter. The deterioration of our merchandise trade balance was even stronger as the deficit reached an annual rate of $44.8 billion in the first quarter of 1978; in the second quarter it improved to $31,2 billion. On the basis of the f figures
published in July and August, the merchandise trade balance improved further still in the third quarter running at an annual rate of $27.6 billion. United States imports of petroleum products have increased
dramatically since 1975, reaching an annual rate in excess of $43 billion in the second quarter of 1978.
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It is generally thought that an export surplus is an indication of economic strength, whereas a deficit is viewed as a sign of weakness. A deficit suggests that a country is uncompetitive in world markets; that it provides fewer jobs for its own citizens and more for foreigners; and that it causes the value of its currency to fall on foreign exchange markets and permits foreigners to acquire its goods and capital assets on the cheap. Although it is true that deficit countries have frequently suffered from sluggish productivity growth and high rates of inflation, it must be emphasized that the view that a trade deficit is invariably a sign of economic weakness is a pervasive and harmful fallacy.
In general, the demand for imports tends to rise if the country has a relatively rapid rate of inflation and/or if it has a relatively rapid rate of real economic growth. In the former case the rise in imports reflects a weakness, namely, the inability to control inflation, but in the latter case the rise in imports is the product of economic strength. Similarly, declining exports may be due to a loss of competitive edge because of inflation and poor productivity performance, but it could
also be due to sluggish economic growth abroad. Thus the weaknesses that cause
imports to rise and exports to stagnate could be local in origin, they could be foreign in origin, or they could be some of both. In any case, no a priori generalization can be made about the relationship between a trade deficit and the economic strength or weakness of any particular economy.
There is considerable evidence which supports the view that the changing distribution of current account surpluses and
and deficits worldwide over the past few years has been largely the result of disparate growth and employment policies pursued by different industrial countries. As shown in Table 1-2, the United States had a surplus in its net exports -- even after paying for its oil imports -- through 1976. However, thereafter U.S. imports grew rapidly, while exports stagnated, The reason is that the United States has recovered more rapidly from the recession of 1974-75 than Germany and Japan, That is the single most important cause of our present trade deficit.
The differences in the real growth rates of the United States and the other major industrialized countries are shown in Table 1-3. With the sole exception of the United States, the average real growth rates of all the major industrial countries in 1976-77 were substantially below their averages for
the 1960-73 period,
GROWTH RATES OF REAL OUTPUT OF
SELECTED INDUSTRIAL COUNTRIES
United States 4.1 5.4
Germany 4.5 4.0
Japan 10.3 5.5
France 5.4 4.1
United Kingdom 3.1 1.7
Canada 5.6 3.7
Source: The Organization for Economic Cooperation and Development.
A narrowing of the growth differentials of the major industrialized countries in 1978 and 1979 would improve the U.S. current account. How much of an improvement, however, can we expect? In testimony before our Committee, Dr. Rudiger Dornbusch replied
to this question as follows:
If fiscal measures raised real
spending in non-U.S. industrial countries by an average of 1/2 percent the effect would work out to perhaps as much as a one percent increase in the rest of the world real GNP, How much of a current account improvement could the U.S.
expect from such a move? Real exports no doubt would increase with differences across commodity
categories that average out to one percent or one and a half percent on the high side. There is some offset, however, from increased raw material prices including the possibility of a rise in real oil prices. Taking this into account, the resulting current account improvements may be as small
as one or two billion dollars. 6/
6/ Testimony of Rudiger Dornbusch, 1978 Midyear Hearings of the Joint Economic Committee, July 18, 1978.
This conclusion suggests that a small change in growth rate differentials will not cause any large change in our current account in any particular year. However, a
sustained increase in foreign growth rates relative to those in the United States will cumulate over time into a significant improvement in our current account. Thus,
given the growth prospects of the United States and the other industrialized countries, we feel it is reasonable to expect a steady improvement in our current account over the next few years.
We believe it is fair to conclude that it has been the relative strength of our economy, not its relative weakness, that has been the source of much of the decline in our net exports.
The second factor that must be considered in evaluating our trade statistics concerns oil imports. While the need for an energy policy is not in dispute, we should recognize that the oil deficit arises in large part from the fact that the Organization of Petroleum Exporting Countries (OPEC) as a group do not have sufficient absorptive
capacity to utilize the f ull amount of the proceeds from their oil sales to purchase imports. If they did have this capacity, our export sales would expand, and this would permit us to pay for our oil. However, since they do not have the absorptive capacity, they must run a surplus on current account, which means someone else must run a deficit. In 1974 and 1975, this deficit was largely shouldered by the developing nations. Since that time, the burden has shifted to a considerable extent to the United States*
There are constructive ways of dealing with our oil import problem. However, attempts to reduce oil imports by quotas and other devices are not among the constructive measures. And we reject outright one of the most effective ways of all of reducing oil imports -- another deep recession. This is not to say that we are opposed to the adoption of a strong energy policy that will spur domestic production and reduce consumption. However, we doubt that current legislation will have much of an impact on our oil imports.7/ For example, the imposition of a crude oil equalization tax could at best reduce U.S. oil imports by about 500,000 barrels a day.
7/ Senator Ribicoff states: "I strongly disagree with this assessment. While the various components of the pending energy legislation offer no simple solutions, we can no longer treat the energy crisis as a shortterm problem. Energy savings will be achieved and our dependence on expensive foreign imports will be reduced. The cost of imported oil, for example, has increased tenfold in just five years, We cannot afford to spend $45 billion annually for imported oil.
Furthermore, failure to take decisive action on the energy crisis is a symbol to the entire world. Our Western European and Japanese trading partners, for example, are starting to believe that the United States lacks the political will to develop and to implement a comprehensive energy program. In the absence of a meaningful energy program there is fear that oil imports will accelerate, that the large trade deficit will continue well into the next decade, and that the dollar will fall still further. We must
Senator Ribicoff's footnote continues:
make clear to the world that we are capable of developing an energy program and enact the pending components of the national energy plan.
A third important influence on the U.S. current account has been the decline in the
value of the dollar on the foreign exchanges. Generally, a reduction in the foreign exchange value of the dollar will cause the U.S, current account to improve because it cheapens our export goods abroad and makes imported goods more expensive. However, in assessing the current account impact of a decline in the dollar, we need to proceed very cautiously.
In the first place, the decline in foreign exchange value of the dollar has been nowhere near as dramatic as is commonly believed. The dollar has fallen sharply relative to the deutsche mark (DM) and the yen (39 percent and 40 percent respectively since March 1973), but these reductions vastly overstate the decline of the dollar relative to the currencies of all U.S, trading partners. Thus, whereas the U.S. dollar has declined in value relative to the DM and yen, it has increased in value relative to the Canadian dollar and the U.K. pound since 1973. Since we import and export goods from a wide variety of countries, it makes more sense to look at the trade-weighted change in the foreign exchange value of the dollar. Using the Federal Reserve Board's trade-weighted exchange rate index, the dollar has declined by only 10 percent since March 1973 to date (August 31, 1978). The decline has not been steady however. The dollar rose in value between March 1975 and June 1976. Since June 1976 it has declined in value by 19 percent.
These statistics cannot be used to measure the change in the relative competitive position of the United States in world markets because at least part of the change in the foreign exchange value of the dollar is attributable to differences in the US.
Chart 1- 3
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inflation rate and those of her trading partners. If United States prices rose by 5 percent more than foreign prices, a 5 percent decline in the trade-weighted value of the dollar would leave the competitive position of the United States unaltered. Adjusting
the U.S, trade-weighted exchange rate by relative inflation rates provides a more accurate measure of the real depreciation of the U.S. dollar. Such an adjustment is made in Table 1-4, using both relative Wholesale Price Index (WPI) and Consumer Price Index
(CPI) changes .
The data in Table 1-4 suggest that there has been a fairly substantial increase in the relative competitive position of the United States since March 1973. After adjusting for differences in inflation, the dollar has fallen 10 to 17 percent relative to the currencies of our trading partners. Between March 1973 and June 1976, there was a
substantial amount of fluctuation, but our competitive position has improved steadily over the past two years,
It is important to note that the abovedescribed exchange rate changes are,, at best.,, crude measures of competitiveness. For example, it makes a great deal of difference whether the exchange rates are adjusted by the WPI or the CPI, The CPI-adjusted rates show an improvement in our competitive
position that is more dramatic than the WPIadjusted rates. Moreover, since what matters is the relative price of tradable goods, we really need measures of price change that are less comprehensive than the WPI or the CPI, Such measures have not been developed, so considerable caution must be exercised in the use of these numbers. Nevertheless, we are
AVERAGE REAL EXCHANGE RATE CHANGES OF THE U.S. DOLLAR
(Percent Decline (-) or Increase since March 1973)
1973 June -1.6 -4.1
December -1.7 +0.6
1974 June -6.0 -2.3
December -1.4 -4.0
1975 June -4.9 -10.1
December +3.8 -2.1
1976 June +4.0 -1.4
December +0.9 -4.6
1977 June +0.3 -6.1
December -4.2 -11.5
1978 March -6.2 -14.6
June -5.8 -13.7
August -9.8 -17.3
Source: Board of Governors of the Federal Reserve System.
persuaded that there has been a fairly substantial increase in the relative competitive position of the United States.
Although the gain iin competitiveness reflected in these figures promises to cause an ultimate improvement in the U.S. current account, there are several reasons why the immediate improvement may not be substantial. The first has to do with what has been called the J-curve effect. In response to a change in relative prices, the current account may change in a manner that looks like a J-curve
-- first down, then ultimately up.
Depreciation has both price and quantity effects. The price effects occur immediately but the quantity adjustments take place with a lag. Thus, the dollar value of imports rise by more than the dollar value of exports causing the current account to deteriorate. Subsequently, however, traders adjust to the price changes so that the volume of imports decreases while the volume of exports increases. When these lagged quantity effects begin to predominate, the current account begins to improve and the upward sloping part of the i-curve is reached. Empirical studies of the timing of quantity adjustments suggest that it may take two or more years before much of an improvement in the current account can be expected.
The increase in the relative
competitiveness of the United States will also tend to be reflected in a larger volume of direct investment on the part of foreign producers. For example, if dollars are cheap relative to marks, it will pay Volkswagen to provide cars to the American market by building a plant in the United States rather than by producing cars in Germany for export,
Chart 1-4CUr\/E EFFECT
Finally, exporters are sometimes willing to reduce their profits by absorbing part of the exchange costs in order to maintain their share of the market. For example, as the value of the dollar falls against the yen, a Japanese producer of autos might reduce the yen price of his exported cars so that the dollar price would rise less than the exchange rate would indicate. The exporter would try to maintain his share of the auto market hoping that the fall in the dollar is only temporary. When it becomes clear that the change is permanent, profit margins can no longer be squeezed, and the dollar price must rise to reflect the new exchange rate.
These forces have been at work in the past couple of years. Therefore, we should start to see some real improvement in the current account in the very near future. We believe it is realistic to expect a net export deficit of only $15 billion for 1978, despite the fact that it is currently running at an annual rate in excess of $17 billion, The
prospects for a further improvement in 1979 are discussed below.
Public Sector Outlook in 1979
There is little that policy can do to influence economic performance during the remainder of the year, However, the decisions that are made now will determine whether economic growth can be sustained throughout 1979. Fear of inflation has produced a conservative policy climate. Probably the best that can be hoped for is that policy -- especially monetary policy -will not become excessively restrictive, so that a recession can be avoided.
33-958 0 78 4
At the time this report was prepared, Congress had not completed this year's income tax legislation. We anticipate that a tax cut between $16 and $20 billion, effective January 10, 1979, will be approved. Unfortunately, a reduction of this magnitude will fall short of canceling out other tax increases that will occur in 1979. Inflation and real growth will push taxpayers into higher tax brackets, producing approximately $13 billion of "fiscal drag." In addition, social insurance taxes will rise about $10 billion. Therefore total tax increases of $23 billion measured against a tax reduction of $16 to $20 billion imply that tax policy will be mildly restrictive in 1979.
Examination of the full employment budget
also indicates that fiscal policy will become more restrictive, As shown by Table 1-5, the full employment budget would move from a deficit of about $5.5 billion in 1978 to a
surplus of about $18 billion in 1979 if there were no tax cut. With the tax cut, the full
employment budget will be roughly balanced in 1979. The movement from a small deficit to balance means that even with a tax reduction, fiscal policy will be more restrictive next year.
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We have no way of knowing how the Federal Reserve Board will conduct monetary policy in the months ahead. In his testimony before
the Committee in late June, Federal Reserve Board Chairman G. William Miller expressed satisfaction with the growth performance of
the economy in the f irst half of the year and stated that he anticipated continuation of moderate, but satisfactory, growth for the remainder of 1978 and for 1979. He went on to add that "inflation must be characterized as our highest priority economic problem." 8/
8/ Testimony of G, William Miller, 1978 'Ridyear Hearings of the Joint Economic
Committee, June 29, 1978,
Translating these subjective statements into a numerical forecast for monetary policy is perilous. Nevertheless, it seems safe to assume that the weakness of the dollar and the recent acceleration of inflation will cause the Federal Reserve to continue to place primary emphasis on inflation control as long as no. sharp deterioration in
production and employment takes place. Certainly this seems to have been the case thus far. While output has grown almost 4 percent and the unemployment rate has held steady in the neighborhood of 6 percent, short-term interest rates have increased 1 percentage point or more, and long-term rates have risen about one-half percentage point.
Since we are not expecting a recession but do expect a continuation of inflation, it is reasonable to assume that monetary policy will continue to be restrictive and that the high interest rates we have been experiencing will continue for the rest of the year and possibly into 1979. We can only hope that the rising trend in interest rates will halt soon. Unfortunately, there are lengthy lags before a change in monetary policy affects spending, so that unless the policy is reversed well before production begins to slow down, the result will very likely be a more drastic slowing of growth than planned, and a possible recession.
For the past year the Administration has pursued a two-pronged antiinflation policy. One part consists of monitoring by the
Council on Wage and Price Stability (COWPS) of government actions which have an adverse impact on the price level. The other part is a jawboning policy that asks business and
labor to limit their price and wage increases to less than the average increases of the past two years, As readily admitted by Barry P, Bosworth, Director of COWPS, the antiinflation program has thus far, and on balance, been a failure, Chapter III of this report contains a discussion of some fundamental alternatives that should be considered for adoption in the war against inflation. Here our purpose is to review the Administration's current policy efforts.
Despite the recent rise in the inflation rate, price monitoring by COWPS appears to have had some beneficial effects. Since January, COWPS has issued numerous reports analyzing the inflationary impact of proposed government activities. For example, COWPS estimated that a quota proposed by the
International Trade Commission (ITC) on
imported television sets would cost consumers an additional $43 per set. COWPS went on to estimate that each additional domestic job created by the reduction in imports would cost consumers $53,000. The President disapproved the ITC recommendation,
presumably in response to the COWPS analysis. Similarly, in July COWPS opposed protective action to limit meat imports because this would have cost consumers about $500 million in higher prices. The ITC found that imports were not the cause of the difficulties
encountered by the domestic meat industry and ruled against the proposed restrictions.
COWPS may also have had an impact on the Occupational Safety and Health
Administration's (OSHA) cotton dust control standards. When Labor Secretary Marshall announced the standards in June, he was careful to note that although there are costs associated with the standards, the costs had been reduced 75 percent from the original estimates,
In other areas, COWPSI evaluations have had little effect, Despite warnings that raising the support price of milk to 80
percent of parity would cost consumers and taxpayers over $900 million and add 0.2 percentage points to the Consumer Price Index for food, the higher level of price supports went into effect, Repeated recommendations to change the Interstate Commerce Commission's restrictive and wasteful regulations of the trucking industry have fallen on deaf ears.
A variety of proposals are now under consideration that would be inflationary iif implemented. The Food and Drug
Administration's proposed saccharin ban, which COWPS estimates would cost consumers over $100 million per year, is undergoing further study. The proposed restriction on sugar imports, which COWPS claims would cost consumers $2.4 billion annually and add a full percentage point to the CPI for food, is also still under cons ide'rat ion. 9/ The ITC 'is considering a quota on copper imports, which COWPS says would cost several hundred million dollars per year. And the Department of Labor has proposed to expand the minimum wage coverage to presently exempted executive and administrative employees. The cost in added labor compensation is estimated to be $500 million.10/
9/ Congressman Long points out that various estimates of the inflationary impact of restrictions on sugar imports have ranged from less than $1 billion to more than $6 billion. However, Congressman Long states that there is good reason to believe that the actual cost involved will not even approach the estimates issued by COWPS, He therefore demurs from the suggestion that such restrictions are greatly inflationary.
10/ All of the estimated costs contained in the preceding paragraph are derived from various reports issued by the Council on Wage and Price Stability. The Joint Economic
Committee has undertaken no independent verification of the COWPSI estimates.
While we are encouraged by the limited success of COWPS in bringing the inflationary consequences of government action to the attention of the public and government
officials, we believe that there is substantial scope for strengthening COWPS and broadening its activities. Even though the Government is not generally an active participant in collective bargaining, it has a responsibility to monitor wage negotiations and to make their inflationary consequences known', COWPSI report on the labor settlement in the bituminous coal industry was very useful. Such efforts should be expanded, and we urge the President to support COWPS as it monitors wage and price developments. We also note that many of COWPSI efforts in the
regulatory area are long-range programs which must be pursued for several years before they begin to bear fruit.
The jawboning effort of the Administration has been notable for its lack of success. An appreciable slowing in the rate of wage inflation is not to be expected in view of the acceleration of price inflation, the heavy bargaining calendar which lies ahead, and the recent willingness of the Administration to accept an inflationary
settlement in order to end the coal strike.
To summarize: Government policy will contribute little to economic growth*in 1979
and the main burden of inflation control will fall once again on the Federal Reserve. Fiscal policy will be neutral at best, and in all probability mildly restrictive. Monetary policy will be dominated by concern with inflation and the international condition of the dollar, and will therefore be restrictive. High interest rates can be expected to continue into 1979. The Administration's anti-inflation policy may
moderate the amount which the Government itself contributes to inflation, but it will do little to slow inflation in the private sector.
Private Sector Outlook for 1979
A wide range of opinion with respect to the outlook for 1979 prevails. The Administration anticipates above-trend
growth, while some private forecasters are expecting a recession. In view of these wide differences, a detailed look at the components of demand is in order.
Until the first half of this year, consumers had provided most of the impetus for recovery. Although the slowdown in the first half of 1978 was quite marked, many forecasters expect even further weakening in 1979. Some forecasters emphasize the steady increase in consumer debt and therefore
forecast a retrenchment in consumer spending. It is true that consumer saving has fallen and installment debt has risen. The personal saving rate fell from 7.7 percent of disposable income in 1975 to 5.7 percent in 1976, and to 5.1 percent in 1977. A large fraction of consumer outlays has been on durable goods. Well stocked with durable inventories, consumers could easily reduce or postpone further purchases.
Other forecasters take a more sanguine view, anticipating that consumption will keep pace with income growth and that anticipated
inflation will produce a buy-now psychology. They argue that despite high interest rates and high levels of consumer debt, the share
of disposable income allocated to the interest payments necessary to service the debt has changed very little, In 1975 consumers spent 2.1 percent of their disposable income on interest, In 1978 they will spend about 2.3 percent, The reason for this lack of growth is the tendency to finance debt over a longer period of time. Therefore even though debt is high, consumers still find the burden manageable. This suggests that retrenchment need not occur either suddenly or sharply as long as high levels of employment and growth
of income are maintained.
Our own expectation is that personal disposable income will grow at a rate of about 3.5 percent in real terms in 1979. Some small degree of retrenchment by consumers is to be expected so that consumption will grow at a slightly slower rate and the saving rate will show a moderate rise.
The recent pickup in business fixed investment, particularly in structures, has been most welcome, As much as we would like to see the revival continue, we do not consider this a realistic expectation, We anticipate that the combination of continuing inflation and high interest rates will cause real fixed investment in 1979 to grow less rapidly than in 1978, If the recent weakening in new durable goods orders continues, it would indicate a slower level
of investment activity beginning early next year,
Housing has remained strong for reasons already noted. Since the 22-30 year age group will be growing, the underlying source
of new housing demand will continue and housing starts will remain in the 1.5 to 2.0 million units range, Homebuyers have shown that they are willing and able to compete with other borrowers as long as funds are available. Nonetheless, tight money poses a threat to housing as it does to other
components of investment spending.
Inventory investment has proceeded in a smooth and normal manner during the current recovery. The absence of overbuilding of stocks is a major reason why a sharp swing iin economic activity is not expected in 1979. The high cost of maintaining inventories undoubtedly helps to account for cautious inventory policies, and the current moderate level of stocks suggests that a slowing of consumption will not cause a sharp unwanted accumulation and subsequent liquidation of inventories.
In summary: we do not expect gross private domestic investment to be a strong source of economic growth in 1979, but neither do we expect it to be an important
source of instability.
It has become increasingly apparent that any analysis of the US, economic outlook must pay careful attention to international economic developments, Exports and imports have grown rapidly relative to GNP and now represent roughly 10 percent of the total -almost as much as business fixed investment. The importance now placed on international economic problems is demonstrated by a continuing series of economic summit meetings among our top government officials, and it is also reflected in this Report, which places
major attention on international monetary ,problems.
Unfortunately, the outlook for the international economy which comes from a ,dispassionate evaluation of world economic .trends is pessimistic. The year 1977 was
characterized by sluggish growth worldwide. This has continued through the first half of ,1978, and the near-term outlook suggests that there will be, at best, only a moderate .improvement, Thus, according to the most .recent economic survey conducted by the Organization for Economic Cooperation and Development (OECD), real GNP growth for the OECD area as a whole is expected to be only !about 3.5 percent for the remainder of 1978 ;and for 1979.11/
ll/ OECD Economic Outlook, No. 23, July 1978,
The economic growth in the member countries of the OECD will be dominated by the behavior of Japan, Germany, and the United States. We have already emphasized that the outlook for the United States is one of very modest growth through 1979. A
similar outlook can also be reasonably forecast fo r Germany and Japan unless they each undertake more expansionary
macroeconomic policies than presently contemplated. Their slow growth is in part the result of the fact that the sharp
appreciation of their currencies over the past year or so has caused their competitive positions in the world markets to deteriorate. This has already had the effect of cutting into their real net export growth, and this trend is likely to continue through at least 1979.
The growth prospects for the developing
nations are also less optimistic for 1978 and 1979. Slow growth in the industrial countries will imply a corresponding slow growth in the export earnings of the developing countries. Additionally, evidence is mounting which suggests that the debt problems of the developing nations are
deteriorating, which could mean a paring down of their development programs,
The major issue for the United States is how much improvement we can expect in our trade position. The continuation of sluggish growth abroad will make it difficult to expand our exports. On the other hand, the fall in the value of the dollar has improved
our competitive position, and as our growth rate slows, our demand for imports will slow as well, We expect these competitive factor s to improve our net exports later this year and we expect the improvement to continue in 1979. Domestically produced goods will tend
to replace more expensive imports, and as time passes exporters will learn of the competitive advantage they can enjoy by moving into foreign markets.
Our net export deficit should be about $15 billion this year and fall to $10 billion in 1979, The decline in the deficit will provide a positive contribution to growth in 1979 since more jobs will be created through export growth than will be lost through
Prices and wages
While we anticipate no major shocks or unusual disturbances in 1979, rapidly rising unit labor costs place an effective floor under the rate of inflation. In the past few years this floor has gradually risen from the 5 to 6 percent range to its present 7 to 8 percent range, and there is no relief in sight,
As noted earlier the productivity performance of the economy has been exceedingly poor, If productivity.follows its typical cyclical pattern, a productivity slowdown would be expected in 1979. But since productivity has been performing so poorly since 1976, it is difficult to know what to expect, Certainly no further
slowdown is likely, and the recent acceleration of capital spending may raise productivity somewhat in 1979. A 1.0 to 1.5 percent rate of growth of labor productivity is as much as can reasonably be expected. Our inflation projection is heavily dependent on the realization of this rate of productivity growth,
In view of the heavy bargaining calendar, 1979 will be a crucial year iin determining the path of wages for the next several years. Catching up to the steep price increases of 1978 and adding some allowance for real income gain will place the average rate of wage increase in the 8 to 9 percent range. To this must be added the large increases in social insurance taxes and another round of minimum wage increases. Even if wages were to rise by only 8 percent -- a very conservative estimate -- this in combination with a 1 to 1.5 percent increase in labor productivity would imply a unit labor cost increase of 6.5 to 7.0 percent. This is the rock bottom inflation floor.
Unfortunately, wages are hot the only determinant of the rate of inflation. The decline in the dollar has increased the cost of imports and this factor will still be working its way through the cost-price structure in 1979, If the dollar declines still further, the situation will be that much worse. There is also the possibility that those commodity imports that are priced in dollars -- especially oil -- may be raised in price because of the decline in the purchasing power of the dollar. The outlook for food prices is fairly good, although this is always difficult to predict because of the vagaries of the weather, And finally, interest rates have reached the point where they add a substantial amount to the cost of borrowing. All of these factors argue for an inflation rate of over 7 percent in 1979.
Summarizing the outlook for 1979, we expect the economy to slow down to a rate slightly below its long-term trend. Recession is a possibility but not, in our view, the most likely outcome, The slowdown
will be accompanied by a poor productivity
'performance and approximately the same inflation rate as 1978, The unemployment
rate will rise modestly from the 6.0 to 6.25 percent level anticipated for the end of 1978. If productivity grows more rapidly than anticipated, this will imply a lower inflation rate, but it will also imply a higher unemployment rate,
33-958 0 78 5
II, KEY INTERNATIONAL ECONOMIC ISSUES 1/
The problems facing the world economy continue to be serious, though crisis has been avoided. Huge payments imbalances, high rates of unemployment, low rates of capital formation, sluggish productivity growth, and high inflation rates abound; and the prospects for improvement in these areas, remain uncertain, The debt problems of the developing countries are debilitating, and the financial structure that supports this debt is potentially unstable, Trade and capital restrictions are on the increase. And finally, the recently instituted system of floating exchange rates is under attack and showing signs of strain.
Many industrial countries are reluctant to undertake policy measures designed to improve their growth rates for fear of unleashing renewed inflationary pressures, Thus, it would be surprising if the German economy attained a growth rate of even 2.5 percent in 1978, and the Japanese performance is also likely to be lackluster by historical standards, Whether or not a significant improvement in the growth of these economies can be expected in 1979 is very much in doubt.
l/ Senator Ribicoff states: "This chapter combines a review of international economic problems facing the United States with review of monetary theories which more properly
belong in scholarly journals,
Senator Ribico f's footnote continues:
"I found especially useful the section on the need for future coordination of macroeconomic policies, and the potential damages of expanded protectionism. The point that exchange rate management will continue to be a key characteristic of the international payments system should be underscored. There should be better-defined rules of conduct for this management,
"I disagree that such guidelines should rule out the occasional use of domestic monetary and fiscal policies for external purposes. Further, I do not accept ruling out the occasional need to restrict movement of goods and*capital internationally. Specifically, I wish to disassociate myself from the sentences and paragraphs footnoted later.
"While the practical issues raised in this report are valuable, I question the value of using the forum of this Congressional publication to endorse or refute a number of academic debates on monetary theory. This is not the substance of normal Congressional discussion. I think that such academic
exercises should more properly be pursued in scholarly publications.
"The chapter's conclusions- regarding US, participation in subsidizing OPEC loans to third world countries and backing
expropriation insurance for such loans detract from the more practical worth of much of this paper."
Continued slow growth on the part of the major industrialized countries could threaten further the growth prospects of the developing -nations. This sluggishness not only limits their export potential but causes the industrial countries to be less receptive than ever to developing country requests that their exports be given preferential treatment.
The payments imbalances that characterize the world economy are alarming. The current account deficits of the developing nations are monstrous despite recent improvements, And among the industrial nations, the huge US. deficit contrasts sharply with the equally huge surpluses of Japan andGermany,
The problems that characterize the world economy raise the risk that there will be a return to protectionism and economic
isolationism that could interfere with both the flow of trade and its growth, What is at stake are the principles of economic liberalism and international financial cooperation that have been the hallmarks of the world economic system since World War II, The principal problem in our view is deficient economic growth. Unless the world's economies undertake policies to raise their growth rates and do so in a coordinated fashion, the trend away from a liberal international economic order will continue.
Stagnating world economic conditions and payments imbalances are threatening to undermine the smooth functioning of the system of floating exchange rates that came into being in the early 1970s. This is particularly worrisome to the Committee because we have long been persuaded that floating is the only exchange rate regime that is viable under today's world economic
conditions. While there is no serious move afoot to return to a system generally fixed rates, there is much dissatisfaction with the consequences of floating -- partly based on a lack of understanding. By contrast, fixed rates under present conditions would foster the imposition of trade and capital restrictions and the use of restrictive macroeconomic policies, all of which would be ,detrimental to the economic health of the :world economy.
We do not suggest that floating is a panacea for the world's economic ills. it will not by itself ensure world prosperity. We believe that world prosperity is best served when each country pursues sound macroeconomic policies designed to foster growth, high employment, and reasonable price stability; when restrictions on the movement of goods and services internationally are significantly reduced; and when improvements are made in the recycling of funds from countries with large surpluses to deficit countries. Floating can facilitate the process of achieving world prosperity by providing sufficient price flexibility to rectify international payments imbalances. Price flexibility is essential to the adjustment process but is absent under fixed exchange rates.
For reasons that will be outlined in this chapter, we are concerned because the world economy may be unwittingly moving along a course that could end in an effort to reestablish fixed or near fixed exchange rates, Abroad, more than 'in the United States, this is still a lingering dream. That, in our view, is precisely the wrong course to follow. We need more exchange rate flexibility, not less,
stable exchange rate system is desirable. Wild exchange rate gyrations of the kind that contribute needlessly to uncertainty and to the disruption of orderly trade and payments do not serve the interests of the world economy. However, in the face of underlying world economic and financial instabilities and uncertainties, even a well
functioning and "stable" floating system will exhibit considerable volatility in the movement of exchange rates, Thus, if volatile exchange rate movements are present, the question needs to be asked whether the
problem lies in the form of the payments system or in the underlying economic conditions of the world economy. If the
problem lies with the system of floating, the system should be scrapped. If the problem lies elsewhere, the source of the problem should be identified and corrected, and
floating should be retained. There is a great deal at stake and a scrapping of the payments system for the wrong reason could cause a great deal of harm.
Consideration of these issues at this time is important. A few weeks ago the dollar
dropped sharply in value on the foreign exchanges, bringing a vast outpouring of worldwide criticism against U.S. economic policy. At home and abroad, the dollar's decline was widely interpreted as a worldwide vote of nonconfidence in U.S. economic policies and U.S. leadership. In response, the Federal Reserve forced interest rates up and dropped the reserve requirement on foreign borrowings of US, Federal Reserve member banks. In addition, the
Administration agreed to double the size of
its monthly gold offerings starting in
iNovember, and there has been much speculation that the Administration is now seriously considering massive intervention in support of the dollar.
The dollar has been subjected to intense downward pressure before, most recently last fall and winter. These declines have added to our inflation rate. The growing uncertainty over the stability of major international currencies may well have also retarded investment and thus slowed world growth. Additionally, the sharp fall in the value of the dollar has forced rather sharp adjustments in the export industries of a number of our trading partners. These events have caused a great deal of understandable concern both here and abroad, and they have raised anew the question of the advisability of retaining our present international payments system, On the basis of our study of floating exchange rates, it is our view that floating should be retained, and that it should not be interfered with nearly as much as at present.2/
2/ Senator Ribicoff disagrees with this
sentence. See his comment at the beginning of the chapter.
We conclude that there ought to be less tinkering with the present payments system and more concern with the absence of a worldwide approach to coordinated
macroeconomic policies based on a serious multilateral commitment to growth and prosperity. We urge the reduction of restrictions on the movement of goods and capital and we call attention to the need for a continuing improvement in the recycling of funds from surplus to deficit countries,
The Present International Payments System
The present international payments system contrasts sharply with the former Bretton Woods system of fixed-but-adjustable par values. Under Bretton Woods, the value of the dollar was fixed in terms of gold, and the value of all other currencies was fixed in terms of the U.S. dollar. In order to ensure the maintenance of the fixed rates, countries agreed to follow certain rules. Thus, the U.S. stood ready to convert gold for dollars at a fixed price, and all other' countries stood ready to buy or sell their own currencies at fixed prices whenever market forces were operating to push their exchange rates up or down.
Countries also agreed to change their fixed rates -- i.e,,, to realign the foreign exchange value of their currencies -- in cases of "fundamental disequilibrium." The meaning of "fundamental disequilibrium" was never precisely defined but was frequently interpreted to mean the existence of persistent international payments imbalances. However, as the Bretton Woods system evolved, it became apparent that the world's nations frowned on frequent exchange rate adjustments. The emphasis was on the fixed,
not the adjustable, part of the system. The devaluation or revaluation of a currency was to be used only in response to a crisis, and only when all else had failed.
During the first twenty years or so of Bretton Woods there were, in fact, remarkably few exchange rate realignments. In part, this was the result of the fact that the underlying economic conditions that
characterized the world economy over much of that period of time were stable enough that repeated exchange rate adjustments were not called for. But when underlying economic conditions became less stable -- as they did ~in the late 1960s and early 1970s -significant realignments took place with increasing frequency. And given the crisis atmosphere that surrounded each devaluation
Sand revaluation, the Bretton Woods system became strained and finally gave way to a more flexible payments system.
Bretton Woods collapsed sometime during ;the early 1970s, It is difficult to pin down the precise date of its collapse, since between 1971 and 1973 the world economy vacillated between a system of floating rates and fixed rates of exchange. The suspension of gold convertiblity by the United States on August 15, 1971, constitued the first official step in the direction of abandonment of Bretton Woods, This was followed by a brief period of floating, which was followed in turn by the reinstitution of fixed rates in 1972. However, pressure to abandon support of fixed rates became overwhelming in the early part of 1973, and when Germany finally decided on March 19, 1973, to let its exchange rate go free, the Bretton Woods system was dead, Since that time, floating in one form or another has been a persistent
characteristic of the international payments system, .$/
The payments system that has evolved since the collapse of Bretton Woods is difficult to describe. It is not a floating exchange rate system in the sense that all of the world's economies are floating simultaneously. On the contrary, the vast majority of the
world's currencies are pegged to one or more other currency, creating, thereby, several currency blocs. According to the latest available information, 42 countries are pegging their currencies to the dollar, 14 to the French franc, 5 to the pound sterling, 14 to the SDR, and 17 to some other currency composite. 3/
3/ International Monetary Fund, 29th Annual Report on Exchange Restrictions, 1978, p. 25.
Nearly all developing countries peg their .exchange rates. Having no well-developed .domestic capital markets, their currencies .cannot be traded privately, and exporters and .importers must deal directly with their
central bank to obtain foreign exchange and local currency. For such countries, floating is not a viable alternative,
A somewhat different kind of currency bloc ,.is provided by the European "snake" (whose .present membership consists of Belgium'Luxembourg, Denmark, Germany, The
Netherlands, and Norway). Under that .arrangement, member countries observe narrow I,exchange rate margins with each other but float collectively against the dollar (hence the reason for the designation "snake in the tunnel"), The IMF approves other exchange rate arrangements as well: some countries allow their currencies to float relatively ,freely (e.g., the United States, Canada, France, Japan, Italy, and the United Kingdom) while others peg to one or more currencies but adjust those pegs periodically in response to changes in certain economic indicators (e.g., Argentina and Brazil),
Despite the many exchange rate arrangements, the present system is essentially a floating system, The bulk of the world's trade is conducted between countries which, technically, are floaters.
And although a lot of countries peg their exchange rates, they do so with respect to the floaters (or with respect to currency composites the values of which are heavily dominated by the floaters) so that variations in exchange rates between floaters implies corresponding group-wise variations in the exchange rates of the countries constituting the respective blocs. Germany, for example, is not technically described as a floater,
but because the vast majority of its trading partners are, Germany's currency floats de facto.
and the Need for Survei 1 ance 4/
Currently exchange rates float, but they are not determined solely by the free interplay of demand and supply. They are also heavily influenced by official intervention in foreign exchange markets and lby other forms of rate management. Indeed, official rate management has emerged as one of the key characteristics of the present
exchange rate regime.
4/ Congressman Hamilton states: "I agree tEhat flexible exchange rates have served us well and that the Bretton Woods system of fixed exchange rates would have proved unworkable at the present time. At the same time, we cannot turn our back on a special international responsibility that comes with the dollar's role as the world's principal reserve currency, Sharp and disorderly fluctuations in the dollar create the kind of uncertainty that can affect trade and investment decisions. The result can be a loss of growth and employment opportunities for many nations.
"In addition, sudden international
adjustments can cause severe political
-difficulties for many of our allies. The sheer rapidity of the dollar's fall against the currencies of Germany and Japan has already created a severe threat to their export industries. In light of Germany and Japan's strong surplus on current account, some adjustment was to be expected. But large year-to-year changes in export markets can lead to serious economic dislocations."
The purchase and sale of foreign exchange by central banks is the most common form of rate management; however, intervention is by no means the only way of managing exchange rates. Exchange rates can also be managed through the use of official or quasi-official borrowing and lending, through controls on the movement of goods and capital internationally, and by the use of domestic
monetary and fiscal policies.
The trend is difficult to quantify, but the world economy has been moving in the direction of greater exchange rate management. The extent to which intervention has been used to stop the dollar's decline is crudely reflected in the net change in
foreign official holdings of reserve assets, Whereas exchange market intervention according to this indicator amounted to about $7 billion in 1975, it rose to $18 billion in 1976 and mushroomed to $37 billion in 1977. On the basis of first quarter figures only, the annualized net change in foreign official reserve assets for 1978 could exceed $60 billion. If the recent sharp decline of the dollar causes foreign and U.S. central banks once again to intervene massively to stem the decline, intervention amounting to $60 billion could easily occur.
We note the trend toward greater rate management with alarm, not because we are. opposed to intervention under alll circumstances, but because it appears to us that the world economy is in danger of drifting back haphazardly toward a system of fixed par values; or worse still, towards an' international payments system characterized not only by fixed rates, but also by exchange controls and trade restrictions.
We recognize that exchange rate management is,, and will continue to be, a key characteristic of the international payments system. However, there do not as yet exist zany well-defined rules of conduct with respect to the management of exchange rates. ,Article IV of the amended Articles of ,Agreement of the International Monetary Fund (IMF) does contain a number of loosely and vaguely defined principles governing the duties and responsibilities of national authorities and the IMF under the flexible ,,exchange rate system. But effective rules of conduct cannot be developed until the nations of the world reach agreement on the basic issue of whether they want a floating exchange rate system that puts primary reliance on market forces, or whether the general preference is for exchange rate managementen. If the recent past is any guide, we are in danger of resolving the issue de facto in favor of rate management. In the absence of any generally agreed upon rules of conduct, it is possible that national authorities will pursue exchange rate policies that serve their own narrow selfinterests only. Although such policies may ultimately prove to be self defeating and detrimental to world trade and development, this does not prevent short-run expediency
from leading to their adoption.
In our view, the surveillance issue should be resolved as follows:
(1) For the industrialized countries, we urge the adoption of an exchange rate system that is, for the most part, cleanly
(2) For those countries that float, intervention in foreign exchange markets
should not be undertaken except to combat or to prevent the emergence of disorderly.
market conditions; and
(3) Additional rules of conduct governing the domestic policies of the respective national authorities should be devised, their objective being to ensure that each of the world's economies adopt policies to foster growth, high employment, and
reasonable price stability.
Under no circumstance should countries be permitted to manipulate exchange rates to their own domestic advantage; for example to protect the competitive position of their export industries. These guidelines would require that domestic monetary and fiscal policies be aimed at domestic growth and price stability rather than at influencing the exchange rate, And finally they would rule out the use of policies to restrict the movement of goods and capital
These guidelines reflect our strongly held view that the free movement of goods and capital internationally is important for world prosperity and that a system of cleanly floating exchange rates is the best means of ensuring such free movement, This does not mean that each and every country must float freely. However, it does mean that the dominant industrial countries must accept the. principle of clean floating and reject any other arrangement -- including currency unions -- if these arrangements interfere with the free movement of goods and capital.
During the 1970s the world economy has been buffeted by a series of major shocks. One set of shocks was the tremendous currency revaluations that were the legacy of the rigid Bretton Woods system. Another shock was the inflationary monetary expansion that accompanied the reluctance of several major countries to accept the floating rate system, A third shock was the very poor harvests that plagued world agriculture during the early 1970s. Perhaps the most damaging shock was the quadrupling of oil prices by the OPEC nations in 1974. This created enormous dislocations and structural problems that have still not been ironed out. Furthermore, the problems of the 1970s have been
compounded by the circumstance that the world business cycle is out 'of phase. As noted earlier, this has been responsible for the sluggishness of our export growth and this has accounted for much of our current account deficit since 1977 and therefore for the pressure on the dollar. Under the circumstances, it is something of a miracle that the international payments system has functioned as effectively as it has, To be sure, there have been periods of extreme exchange rate volatility, but these must certainly be largely attributed to the many adverse underlying conditions that have beset the world economy and cannot be attributed to destabilizing speculation or to any inherent weakness in the system of floating exchange rates.
33-958 0 78 6
Exchange Rate Determination Under a
Cleanly Floating System
Exchange rate movements are the product of a number of complex short-run and long-run forces. Because of its importance to the world economy, this issue warrants analysis in some detail. From a long-run perspective, one of the dominant forces governing the movement of exchange rates between countries is the relative movement of their respective price levels. One hypothesis -- known formally as the Purchasing Power Pa (PPP)
theory of exchange rate movements -- asserts that a rise in the U.S. price level relative to prices abroad will be reflected in an equiproportionate depreciation of the dollar, If this happens, the competitive position of the US, economy relative to other economies will remain the same, and balanced trade will tend to be restored.
Charts II-1 through 11-4 trace the relationships between movements in price levels and movements in exchange rates. The exchange rate curve on each of the four, charts shows the dollar price of each of the respective currencies -- the yen, the DM, the Canadian dollar, and the pound sterling. An increasing (decreasing) index indicates a depreciating (appreciating) dollar. The price curve shows the ratio of the index of U.S. prices to the price indices of Japan, Germany, Canada, and the United Kingdom, A declining (increasing) ratio implies that U.S. prices are falling (rising) relative to foreign prices. On the basis of the PPP theory, we should expect to find a declining ratio of U.S, to foreign prices to be
associated with an equiproportionate appreciation of the dollar, As is apparent from these four charts, however, the nature of the relationship is only approximate. it
ANN & O
holds fairly precisely for Canada and the United Kingdom but is much looser for Japan and Germany. Thus the PPP relationship is not exact either with respect to the timing or the magnitude of the exchange rate
There are several reasons for the absence of a precise correspondence between the
movement of exchange rates and relative price levels. First because traded and nontraded goods are not perfect substitutes, the movement of relative national price levels reflects only imperfectly the prices of exports and imports, which is what counts when assessing relative competitiveness. Second, many factors other than relative prices affect the competitive position of each country. For example, a basis for trade can arise from product innovation and from the unavailability in some countries of specific natural resources, Third, the relationships displayed in Charts II-1 through 11-4 really do not test the PPP relationship because exchange rates over this period of time were partly managed and not permitted to float cleanly. Because of the rapid growth in central bank intervention in foreign exchange markets as the float progressed, exchange rate movements came to reflect less and less the change in relative inflation rates. Finally, since the PPP theory is implicitly based on the notion that all changes in the exchange rate are attributable to forces affecting the current account, the theory ignores the influence of capital flows on exchange rates. Although the relationship is loose, there nevertheless
is a clear tendency for the secular trend of exchange rate movements to mirror, though not exactly, the trend movements of relative national price levels. This is what is most often meant by the assertion that exchange
rate movements should reflect underlying fundamental conditions. However, 18 months to two years or more are required for
relative price changes to have their full effects on import and export industries. And it is only the long-run secular movement of exchange rates that should reflect such fundamental changes. Short-term fluctuations in the exchange rate are quite another matter, For the most part,, they are
determined by a different set of forces, largely those associated with the factors responsible for the movement of capital internationally,
Short-term capital is normally thought to flow in response to risk-adjusted expected yield differentials between domestic and foreign financial assets. According to the traditional view, when international capital is highly mobile, funds will seek the
financial markets with the highest yields, and capital movements will continue as long as the yield differential persists,
A competing hypothesis that has gained considerable support in recent years is known as the' asset-market th Again funds flow
in response to yield differentials, but in this case it is recognized that in order to induce investors to hold ever larger quantities of one asset relative to other
assets, the yield on that asset must be steadily increased relative to the yields on the other assets. There is therefore a very important distinction between the traditional "flow" theory and the asset-market theory, In the former, a constant domestic-forelgn yield differential implies a constant flow of capital per period of time. In the latter, for the necessary stock adjustments to occur, maintenance of a constant flow of capital will require ever wider yield differentials.
An implication of the asset-market theory is that a one-time increase in interest rate differentials will have only a temporary effect on the exchange rate. To illustrate, suppose the expected yield on German securities rises. This will induce American, German, and other investors to change the composition of their portfolios in the
direction of a greater proportion of assets denominated in deutsche marks. Capital will flow into Germany, and this will cause the deutsche mark to appreciate while other currencies, including the dollar, will depreciate, However, once portfolios have been adjusted, the flow of capital will cease, and the dollar and other currencies will move back toward their original values.
The up and down movement of exchange rates in the short run can be seen to be a natural consequence of compositional shifts in portfolios. Since the factors that influence the expected yields of different assets can vary sharply over short periods of time, and since capital flows can move very quickly iin response to changes in expected yields, exchange rate movements can exhibit a great deal of short-term variability. However, this in no way implies that foreign exchange markets are unstable, Indeed, the stockadjustment mechanism suggests quite the opposite.
The asset-market theory implies that exchange rates are determined by all those factors that affect relative expected yields and relative risk. Not only will changes in interest rate differentials cause portfolio shifts and corresponding exchange rate movements, but portfolio readjustments can also come about as a result of other forces* For example, a threat by OPEC to establish a new pricing system for oil based on a basket
of currencies instead of just the dollar could well induce investors to adjust their risk-adjusted relative-expected yields iin favor of nondollar denominated assets. Or if foreign exchange market analysts revise downward their expectations regarding Western European and Japanese inflation rates, and/or revise upward their expectations regarding U.S' inflation rates, the asset-theory would predict a sharp downward movement in the exchange value of the dollar in response. Or finally, if market participants expect central banks to intervene on behalf of a currency, this can also affect expected
relative yields and relative risks, which in turn can cause sizable short-run capital flows. In sum, changes in exchange rates, like changes in stock prices, can come about as a result of changing expectations, fears and hopes. Although these movements can at times appear to be irrational, they are an unavoidable characteristic of free markets in the face of underlying instabilities and uncertainties. Volatile short term movements of exchange rates are not per se a reason to
It is clear from Charts 11-5 and 11-6 that short-term fluctuations in exchange rates are determined by more than just the interest rate differentials between countries. From Chart II it is clear that the up and down
movement of the DM-dollar rate corresponded in a rough way to the up and down movement of the U.S,-German interest rate differential until the beginning of 1977. However, the correspondence appears to be perverse thereafter. And in Chart 11-6, a similar kind of perverse relationship between the yen-dollar rate and the U.S,-Japanese interest rate differential is implied.
ol a Imu>
TOI Aoo Aof%:~
%A ?EI 1I JY srnliti
_0~ ~-~5~4 ~d~l~it
Are Volatile Exchange Rate Movements
the Result of Destabilizing Speculation?
Since it is difficult to construct an accurate test of the complete asset-market theory -- in large, measure because there do not exist accurate measures of expectations, fears and hopes -- we can perhaps approach the question of exchange rate volatility from a different angleO Specifically, is there
evidence to suggest that the observed
volatility is the result of destabilizing speculation?
On the basis of the empirical work that has been done to date, there is no evidence to suggest that -,the observed volatile i movements have been exclusively or even largely the result of destabilizing speculation, There is some indication that speculation was destabilizing during the early part of the float, but that it has become much less so as the float has
prog re ssed.. 5/
5/ See Thomas D. Willett, Floating Exchange
-Kates and International Monetary Reform
(Washington, D.C.: The American Enterprise Institute, 1977) and references cited therein,
It cannot be denied that there have been some bouts of speculative activity in the latter part of the float that, in retrospect, turned out to be destabilizing. The sharp decline of the dollar which began on August 14 of this year and the gyrations experienced in the foreign exchanges that followed might well qualify as one such bout. But looking at the period as a whole, there is little evidence to support the view that speculation has been systematically destabilizing. Moreover, in our estimation, the
destabilizing speculative activity that apparently existed in the early days of the float in fact could have been the result of the relative inexperience of market participants with floating rates.
It is important to deal with another alleged source of exchange rate volatility -namely, the huge volume of dollar-denominated assets in the hands of foreigners. it is
true that foreigners hold upward of $600 billion worth of dollar-denominated assets, It is also true that the sale of as little as 10 percent of these assets could cause a dramatic decline in the value of the dollar. But what do these facts prove? That people will undertake to sell this quantity of assets just because they have such a huge quantity? Probably not. But apparently, according to advocates of this view, the sheer volume of these assets poses a threat in the following way. Any development which could adversely affect the value of the dollar will cause a massive shift out of dollar-denominated assets, causing the dollar to plummet sharply, and if the volume of dollar-denominated assets had been much smaller, the decline of the dollar would have been more moderate.
The difficulty with this view is that it confuses the volume of dollar holdings with the forces that motivate capital movements. In the first place, if people feel generally that the dollar will depreciate by 10
percent, they will instruct their foreign exchange dealers to sell dollars which has the effect of forcing the dollar down. Once the dollar has declined by 10 percent, and as long as expectations remain unaltered, they will undertake to buy or sell dollars in amounts required to maintain the rate at that ,new level. They may mistakenly oversell or undersell the dollar, but the volume of
dollars sold will not necessarily be too extensive just because the volume of dollar 'holdings is extremely large. Put
differently, the amount of dollars sold could well be the same whether the volume of dollar-denominated assets is $10 billion, $60 ,billion, or $600 billion,
Moreover, foreign exchange markets provide a mechanism for speculating against the dollar without having to own dollars. Also 'U.S. residents have the ability to use their own dollar holdings to speculate against the dollar. Consequently, we see little reason to isolate foreign dollar holdings. In short, the present argument mistakenly Singles out foreign dollar holdings from all Ithe potential sources of international capital mobility,
Central Bank Intervention in
Foreign Exchange Markets
Volatile. changes in exchange rates pose a dilemma for central bankers who undertake to intervene in foreign exchange markets when they become "disorderly" since volatility se does not necessarily mean that the market is disorderly.
The Committee has defined a disorderly market as follows:
Disorder emerges in exchange markets when for any reason dealers are unable to form reasonably firm expectations about direction or extent of exchange rate movements in the immediate future. In effect, fear overwhelms normal expectations upon which the ability to do business is based. Disorder is manifested by unusually wide spreads between bid and asked prices for currencies and
by a severe drop in the volume of
transactions from normal levels.6/
6/ "Exchange Rate Policy and International Monetary Reform," Joint Report of the
Subcommittee on International Trade of the House Banking Committee and the Subcommittee on International Economics of the Joint Economic Committee, August 1975, p. 6.
The practical difficulty with this definition is that it is not possible, except in retrospect, to distinguish a disorderly market precipitated by an unexpectedly sharp change in basic trends from one caused by purely transitory factors. If the factors responsible for the exchange rate change are purely transitory, they should reverse themselves in a relatively short period of time.
If governments err and intervene to arrest the movement of exchange rates caused by changes in basic market trends, they will only delay the necessary processes of adjustment, Indeed central bank intervention could itself be a source of exchange market instability if it increases uncertainty by forcing traders and investors to guess where, when, and by how much central banks might intervene,
Despite the practical difficulties of defining a disorderly market, we still
consider intervention permissible-to combat or to prevent the emergence of characteristics normally associated with disorderly markets. However, in view of the potential dangers of intervention, any commitment by the United States should be minimal. If intervention appears necessary, this should be done cautiously and on a very modest scale,
We have frequently questioned the magnitude of the intervention operations undertaken by a number of the major industrialized countries most
particularly, by Germany and Japan in the past year, and by the United Kingdom in 1976, The argument that these operations were undertaken to combat market disorders is not persuasive. In each instance, intervention
was undertaken for extended periods of time, and all of it was in one direction, Despite the substantial interventions, they have not been successful in arresting the slide of the dollar, The underlying economic forces that caused a fall in the dollar have simply been too powerful.
Despite the most recent sharp decline in the value of the dollar, we do not believe the United States should allow itself to be pushed into stepping up its foreign exchange intervention. Intervention interferes with the adjustment process, and much of it, as will be explained later, has the effect of slowing growth in our economy.7/
If other governments wish to intervene to stem the dollar's decline, that is their
business. But we. should not cooperate in such a potentially costly venture, since it would mean slowing our own economy while supporting the competitiveness of foreign export industries and promoting foreign employment at the expense of our own. it
must be understood that such a policy stance means (on occasions such as the 1977-78 period) an acceptance of a decline in the foreign exchange value of the dollar. There is no need to wring our hands in dismay when the international adjustment process requires a lower exchange rate for the dollar. This is psychologically difficult for some people to accept and it creates needlessly alarming headlines, But it is an essential feature of a floating system in the face of a U.S. balance of payments deficit.8/
7/ Senator Ribicoff disagrees with this
para. raph. See his comment at the beginning of the chapter.
8/ Senator Ribicoff disagrees with this
paragraph, See his comment at the beginning of the chapter.
The Use of Monetary Policy for
Normally, official intervention in foreign exchange markets to prop up a sagging currency has effects similar to a restrictive domestic monetary policy. That is, when a central bank enters the foreign exchange market to buy up its own currency, this will : normally lower its foreign exchange holdings,' causing a reduction in commercial bank reserves and a tightening of monetary conditions. This is not, however, what happens when the Federal Reserve Bank intervenes. Since the United States must, borrow foreign currencies with which to buy
dollars -- that is, since the swap network must be activated -- the increase in commercial bank reserves caused by the Federal Reserve's purchase of U.S. dollars is offset by the reduction in commercial bank reserves caused by the borrowing of foreign currencies.
However, as a result of the foreign loan, the reserves of foreign commercial banks are increased, which eases monetary conditions abroad. Thus, official intervention by the Federal Reserve has effects on foreign money supplies that are identical to those that would result if foreign central banks intervened on their ow n to buy up dollars in order to prevent the appreciation of-their
9/ For a detailed discussion, see Anatol B., Bgalbach, "The Mechanics of Intervention ini Exchange Markets," Federal Reserve Bank of St. Louis Review, February 1978, pp. 2-7.
This difference is worth noting since it
limits the damage to the domestic economy that might otherwise occur from foreign
exchange intervention to combat disorderly markets.
Restrictive monetary policy can prop up the currency in two ways. First, by creating interest rate differentials between domestic and foreign financial markets, it can induce an inflow of capital. However, if the assetmarket theory of exchange rates is correct, such inflows of capital will be temporary, and there will be no permanent rise in the exchange rate, Interest rates, however, will be higher, the money supply will be lower, and the level of economic activity therefore will be lower unless and until the monetary policy is reversed.
The second effect on the value of the currency comes about because the slowing of the economy will improve the current account. There may be less inflation, and the slower real growth will dampen the demand for imports, It was, however, precisely to avoid the need for this method of dealing with a balance-of-payments deficit that made the abandonment of fixed exchange rates an attractive option,
33-958 0 78 7
This was true even before recent evidence showed that the inflation-unemployment tradeoff in the United States economy has deteriorated to the point where the attempt to slow inflation by the use of restrictive monetary policy extracts a prohibitive cost in terms of lost production, growth, and employment, As Arthur M, Okun has noted:
To cut today's inflation rate in half would require a recession deeper than the double-sized 1974-75 decline.10/
10/ Arthur M. Okun, "A 'Social Compact'
to Slow Inflation?," The Washington
Post, August 28, 1978, p. A-23.
We should not sacrifice domestic expansion for the purpose of maintaining the dollar. Nor does it make any sense for us to protect the export industries of Western Europe and Japan by deflating our economy when these countries could bring about a slower decline in the dollar and a slower decline in their relative competitiveness. by undertaking internal policies to step up their real rates of growth.
This Committee has consistently opposed the use of monetary policy to secure
international objectives, and we do so now. We recognize that the central role of the dollar in the world monetary system creates alarm abroad when the foreign exchange value of the dollar declines, and we understand the pressures on the Federal Reserve to respond to these concerns. But these pressures should normally be resisted and the eye of monetary policy should be kept firmly on the
needs of the domestic economy.ll/
Twice this year, once in January and again in August, the Federal Reserve forced
interest rates up to stem the decline of the dollar. This is a futile and harmful use of
ll/ Senator Ribicoff disagrees with this paragraph. See hi's comment at the beginning of the chapter,
12/ Senator Ribicoff disagrees with this paragraph. See his comment at the beginning of the chapter,
Toward An Assessment of Floating Exchange Rates
Our prescriptions stem from our belief that floating exchange rates have served the interests of the United States and the world economy generally. Floating may not be the best of all conceivable exchange rate arrangements, but among the possible realistic solutions, it has turned out to be a better system than we had reason to expect. Since floating became a reality in 1973, exchange controls and trade restrictions have for the most part been relaxed, not increased, and world trade in real terms has increased substantially. We are somewhat alarmed, of course, at the recent increased use of restrictive trade and exchange practices among the industrialized countries, but in our view, these developments have more, to do with the continued sluggish recovery of the world economy than they do with the international payments system, our views
regarding floating rates and fixed rates can be summarized as follows:
(1) Floating has not provided the U. S. economy or any other economy with complete policy independence, But few serious students of international finance ever said that it would. If there were not capital mobility, overall balance-of-payments
equilibrium and balance in the current account would be synonymous. A floating exchange rate would then ensure that the exchange rate would change in a way that would provide equality between exports and imports. Therefore expansionary policies pursued by one country would remain bottled up in that country rather than being transmitted abroad,